Recent Trends in Korea's Fiscal Balance

Korea's government budget has been largely in balance, except for the periods of the 1997–1998 Asian crisis and the 2008–2009 global crisis. In its management of the government budget, the Korean government put fiscal discipline above all else and followed the principle of “spending within budget.” Other objectives of fiscal policy were subordinated to the fiscal balance management.

The fiscal stance was even briefly tightened immediately after the breakout of the Asian crisis in late 1997, in accordance with IMF guidelines, in order to improve current account balance and to stop further depreciation of the Korean won. In 1998, however, as the negative impact of the crisis turned out to be much more severe than had been expected, the Korean government and the IMF agreed to switch to an expansionary fiscal policy. A large proportion of fiscal expenditure during this period was used to bail out financial institutions in trouble. It is widely believed that the expansionary fiscal policy adopted during this period was particularly effective as it provided a stimulus to the economy through money and credit creation in addition to the traditional Keynesian multiplier effect (Lee, Rhee, and Sung 2006). The sharp increase in the government budget deficit in 1998 and 1999 marked a structural break from the long time tradition of balanced budgets in Korea. This departure was made possible because the tradition of balanced budgets had kept government debt at low levels.

Figure 1 [ PDF 34.4KB | 1 page ] and Figure 2 [ PDF 31.5KB | 1 page ] show the time series of Korea's government budget balance and government debt as percentages of gross domestic product (GDP). In Figure 1 presents both the consolidated budget balance and the operational budget balance of the central government. The operational budget balance, defined as the consolidated budget balance minus the social security balance plus redemption of public funds, is used for more rigorous evaluations of fiscal soundness.¹ As the figure shows, government budgets have been largely balanced in Korea, with the consolidated budget balance to GDP ratio and the operational budget to GDP ratio recording 0.2% and -1.15% on average, respectively. 1998 and 1999 were exceptional years in terms of the magnitude of the government budget deficit: the consolidated budget balance as percentages of GDP was -4% in 1998 and -2.5% in 1999. After 1999, the government budget balance to GDP ratio returned to its pre-crisis level.

However, the fiscal balance to GDP ratio in Figure 1 may be misleading because, as Figure 2 shows, the fiscal debt to GDP ratio has been increasing quite rapidly since 1998. Fiscal debt of the general government jumped from 10% of GDP in 1996 to 34% of GDP in 1999 and has remained high ever since. For the central government, the increase in government debt was more gradual but equally large. By 2008, the central government debt to GDP ratio had increased to 29%, not much lower than the general government debt to GDP ratio. The discrepancy between Figures 1 and 2 arises because some components of government debt are not taken into account when calculating the government budget balance. For example, the Foreign Exchange Stabilization Bond issues by the central government to raise funds for stabilization of the foreign exchange market and the National Housing Bond used for public provision of housing services are taken into account when calculating government debt, but not in calculating the government budget deficit. Moreover, public funds that were raised during the Asian financial crisis through the issuance of bonds by the Korea Deposit Insurance Corporation and the Korea Asset Management Corporation were gradually turned into government debt starting in 2003. The rapid increase in central government debt in recent years has been caused by the expansion of these items.

People have different views on the nature of these liabilities. Some argue that they can be offset by corresponding assets and thus the rapid increase in total fiscal debt may not be a serious problem. Others argue that poor management of the funds has incurred losses and therefore can pose a threat to long term fiscal stability. However, regardless of the nature of these particular liabilities, the true fiscal burden of the Korean government is likely to be substantially greater than Figures 1 or 2 may suggest. It is widely known that numerous quasi-fiscal accounts of public funds and public enterprises in Korea are not included in the IMF definition of fiscal debt (for example, Lee, Rhee, and Sung 2006). When these hidden liabilities are added, the fiscal debt figure increases substantially. For example, Ok (2007) argues that, with the liabilities of quasi-governmental bodies included, Korea's fiscal debt at the end of 2007 amounted to about 76% of GDP, almost twice the official figure.²

In 2009, the Korean government ran another major deficit to contain the negative effects of the global financial crisis. Government expenditure increased sharply while tax revenues remained almost unchanged compared to 2008. Preliminary estimates indicate that Korea's consolidated central government budget balance as a % of GDP was -2.1% in 2009 and is expected to be -0.4% in 2010. The operational budget balance to GDP ratio was -5% in 2009 and is expected to be -2.9% in 2010. Due to the sizeable deficit, the fiscal debt to GDP ratio must have further increased in 2009. The Korean government estimates that the general government debt to GDP ratio increased from 32.8% in 2008 to 35.6% in 2009.

Most of Korea's fiscal stimulus was concentrated in the areas of social development and economic development. As Figure 3 [ PDF 55.1KB | 1 page ] shows, the share of expenditure on social development and economic development increased in 2009, while the share of education and national defense decreased at the same time. Social development includes public health, social welfare, housing, regional development, entertainment, etc., and economic development includes energy, industries, transport, communication, etc. These two areas take up almost 50% of total expenditure and also are to a greater extent subject to cyclical fluctuations than other areas. As can be expected, the share of these two areas exhibited a similar increase in 1998. The sharp increase in fiscal expenditure and the heavy focus on large-scale infrastructure investment have raised concerns about possible distortions in resource allocations. In particular, critics argue that the current Lee administration has a strong inclination towards fiscal expansion which may lead to waste of resources. For example, the Four Rivers Restoration Project, a multi-billion dollar project with the stated goals of preventing water shortages and promoting tourism, is being criticized by many as economically inefficient and environmentally harmful. The project may help boost the country's construction sector, but only at the expense of taxpayers.

To summarize, favorable initial conditions of Korea in terms of fiscal debt and contingent liabilities enabled the government to adopt a large fiscal stimulus package in 2009 in response to the global crisis. However, this expansionary policy is likely to accelerate the already rapid expansion of Korea's fiscal debt.³ The rapid increase in the fiscal debt to GDP ratio can be a serious threat particularly because a more comprehensive measure of government liabilities that takes into account numerous quasi-fiscal activities in Korea would likely be substantially greater than the official figures indicate.

In the next section, I examine how Korea's fiscal policy in 2009 fares against typical policy reactions during economic downturns. To do so, I use historical cross-country data from a comprehensive set of countries including Korea. Through this empirical analysis, I intend to determine how counter-cyclical Korea's fiscal response was in 2009 compared with other periods of economic downturn in Korea and other economies. We have seen that most countries, including Korea, recorded substantial deficits in 2009. Strictly speaking, however, a fiscal deficit does not necessarily mean a discretionary expansion. Even without any active discretionary policy changes, the government budget balance would typically turn into deficit during economic downturns because of the existence of automatic stabilizers such as income tax and transfer payments. In other words, the government may record a government budget deficit during a recession simply because the economy is in such a bad shape. To make a proper policy evaluation, one needs to distinguish between cyclical components and discretionary components in fiscal variables and examine how the discretionary components changed during a particular economic downturn. The next section provides such analysis.

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